Posts Tagged ‘Federal Reserve’

Yesterday, the Federal Reserve confirmed that it would end new purchases of Treasury bonds and mortgage-backed securities (MBS)—what’s known as quantitative easing—in October. In response, the media are heralding the end of the Fed’s stimulus:

What the Fed is about to do is stop increasing the amount of stimulus it provides. For the mathematically inclined, it’s the first derivative of stimulus that is going to zero, not stimulus itself. For the analogy-inclined, it’s as though the Fed had announced (in more normal times) that it would stop cutting interest rates. New stimulus is ending, not the stimulus that’s already in place.

The Federal Reserve has piled up more than $4 trillion in long-term Treasuries and MBS, thus forcing investors to move into other assets. There’s great debate about how much stimulus that provides. But whatever it is, it will persist after the Fed stops adding to its holdings.

P.S. I have just espoused what is known as the “stock” view of quantitative easing, i.e., that it’s the stock of assets owned by the Fed that matters. A competing “flow” view holds that it’s the pace of purchases that matters. If there’s any good evidence for the “flow” view, I’d love to see it. It may be that both matter. In that case, my point still stands: the Fed will still be providing stimulus through the stock effect.

P.P.S. I wrote about this last year during the tapering debate. In the lingo of that post, the Fed is moving from quantitative easing to quantitative accommodation. To actually eliminate the stimulus, the Fed would have to move on to quantitative tightening.

James Bullard, head of the St. Louis Federal Reserve Bank, gave a nice presentation on “The Tapering Debate” today. See the whole thing here.

One question he considers is whether the Fed balance sheet is getting scarily big. It’s certainly large by U.S. historical standards — the only time is was bigger, relative to the size of the economy, was in the 1940s.

By current international standards, however, the Fed balance sheet isn’t an outlier. In fact, Japan, Europe, and the United Kingdom all have larger central bank balance sheets, relative to their economies, than we do (FRB = Federal Reserve Bank):

Is the Federal Reserve part of the government? You might think so, but you wouldn’t know it from the way we talk about America’s debt. When it comes to the debt held by the public, for example, the Fed is just a member of the public.

That accounting reflects the Fed’s unusual independence from the rest of government. The Fed remits its profits to the U.S. Treasury each year, but is otherwise ignored when thinking about fiscal policy.

In the era of quantitative easing, that accounting warrants a second look. The Fed now owns $2 trillion in Treasury bonds and $1.5 trillion in other financial assets. Those assets, and the way the Fed finances them, could have significant budget implications.

To understand them, we’ve calculated what the federal government’s debt and financial asset positions look like when you combine the regular government with the Federal Reserve, taking care to net out the debt owned by the Fed and Treasury cash deposited at the Fed:

This consolidated view offers five insights about America’s debt situation:

1. Less long-term debt. The Fed has bought $2 trillion of Treasury debt with maturities of a year or more. As a result, $2 trillion of medium- and long-term public debt is not, in fact, held by the real public. Interest payments continue, but they cycle from the Treasury to the Fed and then back again when the Fed remits its profits to Treasury. (This debt would become fully public again if the Fed ever decides to sell or allows the debt to mature without replacing it.)

2. More short-term debt. The Fed needs resources to buy longer-term Treasuries, mortgage-backed securities, and other financial assets. In the early days of the crisis response, it did so by selling the short-term Treasuries it owned. But those eventually ran out. So the Fed began financing its purchases by creating new bank reserves. Those reserves now account for $2 trillion of the Fed’s $2.3 trillion in short-term borrowing, on which it currently pays 0.25 percent interest.

3. Slightly more overall debt. The official public debt currently stands at $11.9 trillion. When we add in the Fed, that figure rises to $12.1 trillion. Bank reserves and other short-term Fed borrowings more than offset the Fed’s portfolio of Treasury bonds.

4. Lots more financial assets. Treasury’s financial assets now total $1.1 trillion. That figure more than doubles to $2.5 trillion when we add in the Fed’s mortgage-backed securities and other financial assets.

5. Less debt net of financial assets. The Fed adds more in financial assets than in government debt, so the debt net of financial assets falls from $10.8 trillion to $9.6 trillion. That $1.2 trillion difference reflects the power of the printing press. As America’s monetary authority, the Fed has issued $1.2 trillion in circulating currency to help finance its portfolio. That currency is technically a government liability, but it bears no interest and imposes no fiscal burden.

The Fed thus strengthens the government’s net financial position, but increases the fiscal risk of future increases in interest rates. When the Fed buys Treasuries, for example, it replaces long-term debts with very short-term ones, bank deposits. That’s been a profitable trade in recent years, with short-term interest rates near zero. But it means federal coffers will be more exposed to future hikes in short-term interest rates, if and when they occur.

The Fed believes the stimulus from quantitative easing depends on the stock of Treasuries and mortgage-backed securities that it owns, not on the flow of its purchases. If that view is correct, the future tapering of Fed purchases won’t be monetary tightening, it will a slowing pace of monetary easing (click for larger chart):

The chart shows a hypothetical trajectory for the Fed’s bond and MBS holdings. Under the stock view, that trajectory will go through three stages, paralleling those of traditional interest rate policy:

Quantitative easing: The Fed expands its balance sheet by buying Treasuries and MBS. Current pace: $85 billion each month.

Quantitative accommodation: The Fed maintains its balance sheet; it buys new assets to replace older ones as they mature.

Quantitative tightening: The Fed contracts its balance sheet by allowing assets to mature without replacement or, more aggressively, by selling them.

In this view, tapering is the final stage of quantitative easing. The Fed buys assets during tapering, but at a slower tempo. Tapering is not tightening.

That view is clear, logical, and elegant. But it utterly fails to explain why financial markets went haywire last week when Ben Bernanke and company talked about tapering.

One reason is investor expectations. The Fed has been trying to stimulate the economy not only through QE, but also by telling investors to expect easing in the future. Such forward guidance can be a powerful lever for monetary policy.

Last week, investors learned that QE might end sooner than they expected. In the stock view with expectations, that is monetary tightening. As illustrated in the second chart, future Fed policy would be tighter than financial markets had previously thought.*

This view likely explains some of the market reaction to recent Fed statements. But it’s hard to reconcile the magnitude of the movements. Suppose markets expected tapering to begin in January and now think September more likely. All else equal, that four-month difference implies a $340 billion reduction in the Fed’s ultimate portfolio. That’s something, but could that alone explain the sharp market response?

My sense it that something else must be going on as well. Some candidates include:

Perhaps the flow of Fed purchases matters, not just the stock. This view appears much more common among traders than Fed economists. If anyone has a reference for a good articulation of this view, I’d love to see it. The flow shouldn’t matter in normal times—was the Fed tightening when the flow of purchases was essentially zero for decades before the recent crisis?—but these are hardly normal times. Perhaps the flow matters when you are at the zero lower bound?

Perhaps world financial markets expected a much longer period of QE and are highly geared to Fed policy. If I am reading it correctly, that’s the view of Vince Foster who discusses the unwinding of the carry trade (ht Tyler Cowen)

* This definition of tightening compares the new expected trajectory of Fed holdings to prior expectations. Such comparisons are relative; in principle, one could equally say that the Fed announcement indicated that future policy would be less loose, not that it would be tighter. But for most purposes, it seems simpler just to say that future policy has gotten tighter. The same semantic issue exists in fiscal policy. If Medicare spending is scheduled to grow $35 billion next year, what do we call a proposal under which spending increases $30 billion? We usually call that a $5 billion spending cut since it’s a decline relative to an accepted baseline. But we should remember that Medicare spending is growing. The same seems true with early tapering. Tightening seems the cleanest description for most purposes, even though in absolute terms it is slower easing.

The federal government has been borrowing rapidly to finance recent budget deficits. But that’s not the only reason it’s gone deeper into debt. Uncle Sam also borrows to issue loans, build up cash, and make other financial investments.

Those financial activities have accounted for an important part of government borrowing in recent years. Since October 2007, the public debt has increased by $6.9 trillion. Most went to finance deficits, but about $650 billion went to expand the government’s investment portfolio, including a big jump in student loans. Before the financial crisis, Uncle Sam held less than $500 billion in cash, bonds, mortgages, and other financial instruments. Today, that portfolio has more than doubled, exceeding $1.1 trillion:

Financial crisis firefighting drove much of the increase from 2008 through mid-2010. Treasury raised extra cash to deposit at the Federal Reserve; this Supplemental Financing Program (SFP) helped the Fed finance its lending efforts in the days before quantitative easing. Treasury placed Fannie Mae and Freddie Mac, the two mortgage giants, into conservatorship, receiving preferred stock in return; shortly thereafter, Treasury began to purchase debt and mortgage-backed securities (MBS) issued by Fannie, Freddie, and other government-sponsored enterprises (GSEs). And through the Troubled Asset Relief Program (TARP), Treasury made investments in banks, insurance companies, and automakers and helped support various lending programs.

Together with a few smaller programs, these financial crisis responses peaked at more than $600 billion. Since then, they have declined as Treasury sold off all its agency debt and MBS and most of its TARP investments and as quantitative easing, in which the Fed simply creates new bank reserves, eliminated the need for cash raised through the SFP.

Those declines have been more than offset by the government’s growing student loan portfolio. The federal government used to subsidize student borrowing not only by providing loans directly to students, but also by guaranteeing many private loans. In 2009, however, Congress eliminated private guarantees and dramatically expanded direct federal lending. The government’s portfolio of student loans has since increased from about $90 billion at the start of fiscal 2008 to more than $560 billion today.

As a result, the government’s financial investments now total about $1.1 trillion, essentially all of which was financed by borrowing. The debt supporting Uncle Sam’s investment portfolio thus accounts for almost 10 percent of the $11.9 trillion in public debt.

Source: The Federal Reserve Financial Accounts (formerly known as the Flow of Funds), Daily Treasury Statement, and the President’s Budgets. The figures here compare balances as of March 31, 2013 (most recent available) with balances as of September 30, 2007 (the end of fiscal 2007). We define financial investments to be all the federal government’s financial assets except for official reserve assets, trade receivables, and tax receivables; this definition approximates those used by the Office of Management and Budget and the Congressional Budget Office in certain debt calculations.

This post was coauthored by Hillel Kipnis, who in interning at the Urban Institute this summer.